The Downside of Disclosure

Does disclosure work? Daylian Cain, a professor at the Yale School of Management, says that while it's often necessary, it doesn't work the way regulators expect. His research shows it can actually diminish the quality of advice offered and leave consumers worse off for having been warned. It's a fascinating subject to consider today, as financial advisor, investment adviser, regulatory and consumer protection groups continue to debate the merits of extending a uniform fiduciary standard to brokers and broker/dealers who provide personalized investment advice to retail customers. In a Dodd-Frank study delivered in late January, SEC staff recommended just that. If that happens, brokers will have to either eliminate or disclose their conflicts of interest, including any commission-based compensation they get for selling products to the client, or any revenue a broker/dealer firm might get if a financial advisor sells a client a proprietary product. We spoke to Daylian in mid-January, shortly before the SEC's report was released.

Registered Rep.: What sparked your interest in issues of disclosure?

Daylian Cain: I was doing research at Carnegie Mellon as a PhD student and my advisors (Don Moore and George Loewenstein) were working on conflicts of interest. I thought of doing research on disclosure because there's a long line of research on what's called the “anchoring bias,” which suggests that people anchor on, or mentally stick to, suggestions that are given to them even when they know those suggestions are randomly generated. If randomly-generated advice can have a lasting impact on judgment then I worried advice that was biased, even when the bias is disclosed, could have a lasting impact.

People who discount bad advice are still going to be affected by it somewhat, much in the way that if someone spreads a vicious rumor about you and retracts it a week later, the damage has already been done. People find it very difficult to ignore even what they know to be bad information, let alone what they merely suspect is bad. That's what started the research. And then as we were producing these studies, Enron happened, so the research got a lot of play in the media and kind of took off.

Since then we have shown that disclosure can have many perverse effects. In recent work with Loewenstein and Sunita Sah, we show that when an advisor discloses a personal interest in what the audience does with their advice, it puts pressure on that audience to satisfy the advisor's interest and to avoid insinuating that the advisor is corrupt.

RR: Where does the view that disclosure is a panacea come from?

DC: I think it comes from common sense. If I tell you that my advice comes with a conflict of interest, you'd think you could gauge what to do with that. It turns out that's not the case. But there's also pressure, I think, to keep disclosure in the forefront of regulation policy. It's a very simple solution and the alternatives are hard. One alternative would be to eliminate conflicts of interest where possible, and that's difficult. Disclosure serves many masters. It serves the public, because it makes sense that it should protect them. It serves the regulators because it seems to suggest that they're doing their jobs. And the regulated love it because they don't have to get off the gravy train; they just have to announce that they're on it.

RR: Do certain kinds of disclosures work better than others at helping people make good decisions about advice?

DC: I'm not advocating against disclosure. What I'm saying is that it's not likely to do the work that people think it will. That said, others are doing interesting new work to show that for savvy repeat players with many rounds of experience getting advice, disclosure can be helpful. There is also some research that suggests that when the audience can punish the advisor for giving bad advice, that disclosure might work a little better because it keeps the advisor in line. Our own research, with Loewenstein and Moore, suggests that if you pair the disclosure of biased advice with separate unbiased advice, it can work when conditions are just right. And then, cooling-off periods can help — if a doctor or advisor gives you time to think about the advice and disclosure, if you don't sign the dotted line right away.

RR: Are there any clear historical cases where disclosure worked very well, or very badly?

DC: Certainly, you can come to your own conclusions about how effective the tobacco companies' warning labels were. One of the sad things about that is that it was supposed to protect consumers, but it ended up serving as a litigation shield for tobacco companies because they could claim that consumers had been warned. One of the perverse effects that we found in the original research is that disclosure seems to morally license advisors to give worse advice in the first place, because they believe the client has been given sufficient warning — it's the old caveat emptor, buyer beware.

I think people have the right to know what their advisors are up to, whether or not it helps them make the best decision. That said, the real cost of disclosure is in its more straightforward effect. If we treat disclosure as a panacea when it's a sugar pill, it can keep the patient from considering real medicine.